When is a Door Not a Door?

I know what you are thinking when you read the title to this article! You’re thinking, “Good heavens! That title is a real “High School Harry” joke.” And you are right. In fact, I recall that joke from my time spent in the West Shore Junior High School in Lemoyne, Pa. in the late 1950s. But now you might well be asking yourself, “What does the title have to do with accounting and/or income taxes?” Well, the point is that things are not always what they first appear to be. At home I have several devices that are designed to be used to open bottles of wine. Some are battery operated; some have handles that one pulls down to the side of the bottle; and some, at first, resemble a pocket knife. This latter type has a short blade that one uses to cut the foil seal to gain access to the cork. But looking at this device from different perspectives can raise these questions:

Is that “thing” a knife? Is it a foil cutting device?

Or is it just a component of a wine opener?

To some degree, it simply depends upon one’s point of view or vision.

The same issue can arise when looking at what we call a building. Let us assume somebody buys a building to house their manufacturing business. At first glance one might say that we need to allocate the price between land and building. After all, we cannot depreciate land, but we can depreciate the building and get a tax deduction for our building costs. That sounds pretty good, but depreciating a building must be done over a time period of 40 years!! That is a long time over which to recoup the tax benefits of the building. But given the time value of money, and the certainty involved, we would all like to have the money now, or sooner, rather than later. Consequently, let’s look at this again. We have only made a distinction between land and building.

A building has many components. It has columns and beams which hold up the walls and the roof. In most instances, you wouldn’t have much of a building without them. Clearly they are part of the building. But let’s take a closer look. What about that electrical system? Some of it is there to operate the lights and heating and cooling of the building and office. On the other hand, some parts of the electrical system are there for the specific needs and use of specific and identifiable pieces of equipment. The Internal Revenue Code (IRC) and the related regulations allow us to depreciate such components over the same shorter depreciation lives; recoup our tax dollars sooner; and thusly enjoy the benefit of keeping more of our money now and in the very near future. Incidentally, we can do the same thing with land. For example, the cost of getting the land ready to serve as the foundation for a ramp or for a parking lot can be amortized over 15 years, as a land improvement.

Like most of the IRC and related regulations, depreciation rules change from time to time, as our government sees fit. Most of us are familiar with the concepts of “bonus” depreciation, “Section 179” depreciation, and “accelerated” depreciation. We recently performed an engagement like this for a construction company that was erecting its own factory building. The estimated cost for the building was slightly more than $3,800,000. After we completed our analysis, we were able to allocate over $1,085,000 out of the “Building” and into different asset types with shorter lives. This speeded up the depreciation deduction. Based on 2014 tax regulations we estimated that the company’s first year depreciation expense deduction for income tax purposes could be nearly $600,000. Almost one sixth of the total cost in the first year! That is not always possible, but it is certainly worth taking a look at.

This type of accounting analysis has a unique name. It is referred to as ASSET COST SEGREGATION. The brief definition that I usually use is this: “Analysis of building costs to identify deemed building components that might well constitute equipment and be, therefore, subject to faster depreciation and amortization for tax purposes.” The IRC allows this to be done with new buildings and with buildings that have been in existence for some time. It is easier to do with new construction, because of the availability of construction drawings, actual costs, and physical inspection of the components before they might well be covered over by other parts of the building construction.

There is one final bit of good news. This treatment is for income tax purposes and generally does not have to be used for financial statements prepared in accordance with “generally accepted accounting principles.”